Dear Professor Smith,

I'm glad to see you writing for Minyanville. I've always thought you had really sound ideas and think you're in good company.

I'm taking your OptionSmith newsletter and wondered why you took COP as a call buy rather than a vertical debit spread. My modeling shows higher yield over your target price zone with the spread. I'm not arguing here, but know I must be missing an essential part of your analysis.

Cheers,

Minyan Bill B.


Dear Minyan Bill,

This hit my inbox on Wednesday afternoon, shortly after the OptionSmith portfolio was filled on its limit order to buy some ConocoPhillips (COP) April $40 calls at $1.70 a contract.

It’s a good question, as it gets to the heart of how one chooses what the most effective strategy will be, and also aligns with the investment thesis and market conditions.

My first response: The reason I chose an outright purchase over a spread is that I wanted the flexibility to take profits, or make adjustments, in response to changes in price.

Even though my upside target is "only" $45 (COP was trading $37.80 at time of purchase), it could bolt higher quickly, if and when it turns.

Spreads do provide a good risk/reward profile, but that's usually measured based on the price at expiration. In reality, it's hard to realize anything near the maximum profit, unless it's very close to expiry -- say one week or less -- or the spread is deep in-the-money (the further out-of-the-money strike having at least $5 of intrinsic value).

I chose the outright purchase because I didn't want to get handcuffed by the clock.

But keep in mind an option position is like any relationship: Be careful before you commit, but also realize that compromises might be necessary.

Hence, 2 days later I needed to update that answer: As a follow-up, and illustration that option trading is a dynamic process, and not to be stubborn, I’ve made an adjustment and turned the COP position into a calendar spread.

Specifically, I sold the March $40 calls to help reduce the position’s cost and get some time decay or theta on my side.

But I’ll admit, I was kind of forced into this adjustment in that shares of ConocoPhillips have been under pressure following Thursday’s announcement of an outage at one of its refineries. So I used Friday’s higher opening to launch some of the March calls.

The adjustment doesn’t make the position profitable or even more promising. But it does take some of the immediate sting out and buys some time to reassess the situation.

Success in trading, especially in options, is not about the glamour of hitting the jackpot, but the daily grind of position management and risk management.

Covered Calls Coverage

I’ve also been getting a far amount of questions regarding covered calls. At the moment, I’ll refer you to Mark Wolfinger’s excellent article, and his other writings including his book, Options for Rookies. For additional reading on the topic I recommend New Insights Into Covered Calls, by Larry McMillan.

Keep the questions and comments coming.

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